Tax policy and economic growth
SOCIAL SECURITY CONTRIBUTIONS IN CROATIA IN 1998
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- TAX REVENUES OF CENTRAL GOVERNMENT BUDGET AND GDP 1991 1992 1993 1994 1995
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SOCIAL SECURITY CONTRIBUTIONS IN CROATIA IN 1998 Contributions Contribution rate (in percent of gross wage) Contributions assessed on personal incomes: - pension and disability insurance contribution 10.75% - health insurance contribution 9.00% - children’s allowance contribution 2.20% - employment contribution 0.85% Contributions assessed on salaries – total 22.8% Contributions on wages and salaries: - pension and disability insurance contribution 10.75%
- health insurance contribution 9.00%
- employment contribution 0.85%
Contributions on salaries – total 20.6%
Source: Sirovica (1998) Contributions In a larger sense, the system of contributions, or social insurance system, is a part of the tax system of the general government. Contributions are used for financing expenditures of pension and disability insurance, health insurance, children's allowance and employment. This is part of the taxation system that has yet not undergone substantial changes in Croatia. The problem is in the large number of privileges inherited from the socialist system. Since these rights are typically not elastic downwards, reforming social insurance systems in all countries primarily becomes a social and political problem. The overall taxation through contributions in Croatia is among the highest in the world (see Table 7) and it certainly represents a heavy burden for the labor factors, thus reducing the international competitiveness of Croatian products. Nestiæ (1997) proposed their reduction, or transferring part of them to the state budget, or even a full reform of the system of social expenditures. But only a systematic rationalization of social insurance will bring along a long-term final relieve from excessive contributions. As of 1 February 1998, the contributions on wages and salaries and contributions assessed on personal incomes have been paid on salaries at the total rate of 43.4 percent (Sirovica, 1998).
CROATIAN ECONOMIC SURVEY 175
1996 - 1999 The so-called war tax was introduced the same year. In addition to the existing rates 10 of turnover tax on goods and services, the whole retail trade was taxed at a rate of 10 percent. The cascade effect is hard to estimate: some authors (Daliæ, Madžareviæ and Nestiæ, 11 1996) estimate it was 1 percent, while others (Krelove, Temprano-Arroyo and Schenone, 1997) believe it amounts around 4.6 percent. The cascade effects occurred because taxpayers still had to purchase passenger vehicles, office furniture, stationery and liquid fuels and lubricants at retail prices. 4.1.2
Reform of indirect taxes Value Added Tax The reform of indirect taxes was implemented gradually, by means of repeated amendments of the existing sales tax system, which was based on single-stage sales tax in retail trade. The goal of these reforms was to prepare the ground for the VAT system by simplifying the existing Sales Tax on Goods and Services Act (Official Gazette No. 36/91): a) tax rates were gradually reduced, so that overall tax rate for products was reduced from its maximum of as high as 50 percent in 1992 to 26.2 percent (15 percent plus 10 percent of 10 sales tax in retail trade), as it was when VAT was introduced in early 1998, b) the number of tax brackets was reduced from eight for products and six for services down to only four for products and one for services, c) taxation of raw material and equipment was abolished in order to reduce the cascade effect and bring the taxation system nearer to modern taxation of final consumption. Although the goal was to bring sales tax closer to the single-phase final consumption tax, full correction of the tax distortions caused by tax cascading actually failed , 11 d) excise taxes on tobacco and oil products, alcohol and non-alcohol beverages, beer and motor vehicles were introduced in July 1994. Although these changes were important in the modernization of the taxation of consumption, the enactment of the Value Added Tax Act (Official Gazette No. 47/95) on 12 July 1995 was nevertheless the most important pillar of the reform of indirect taxes. The Value Added Tax Act was supposed to replace the single-phase sales tax system as of 1st January 1997, but its application
176 CROATIAN ECONOMIC SURVEY 1996 - 1999 was postponed for a year, that is for 1st January 1998. The gradual approach and caution in the implementation of the reform are understandable if we keep in mind that they represent the most important revenue of the central government budget (in 1993, as much as 72 percent tax revenues of the state budget came from sales tax).
By the introduction of VAT, a sales tax with five tax rates (four for products and one for services) has been replaced by a flat rate of taxation of 22 percent on all products and services in the final consumption. By the introduction of VAT, overall sales tax rate was thus reduced from 26.5 percent to 22 percent, at which all products and services are taxed. According to the Value Added Tax Act, zero rate of VAT is not applied in Croatia (except for products for export) and only a few usual exemptions are envisaged: lease of housing space, services of banks and savings banks, insurance and re-insurance, medical and dental services, social welfare and child welfare and services in education, religion and culture. Besides these exemptions, government administration bodies, unions, political parties and chambers are also exempt from the VAT system; VAT is also not paid for transactions in securities and shares in a business. VAT is based on a consumption type (gross investments are not taxed), on a destination principle (export is taxed at zero rate and is thus fully exempt from VAT, while imported goods are taxed on the basis of the place of spending, that is, with the domestic VAT), and on a credit method of calculation of VAT, which actually never calculates value added, but rather calculates the amount of VAT based on incoming and outgoing invoices. These fundamental determinants of the Croatian VAT Act tell us that this solution fully complies with the recommendations for a successful tax reform. Neutrality of the tax, its economic nature and simplicity of collecting and the range of exemptions are all reduced to a minimum, while a zero rate is applied to export only. Strong as it is, the pressures for introduction of several tax rates in order to relieve regressivity of VAT has failed so far. In modern fiscal systems, regressivity of VAT is relieved by increased progressiveness of other tax forms or direct transfers to vulnerable categories of the population. Such method of achieving vertical equity is much more efficient than achieving the same goal with a larger number of VAT rates: fewer distortions are introduced to the system, assistance goes to those who really need it, indirect subsidizing of the rich is avoided, the costs of tax collection for both tax administration and taxpayers are reduced and the pressure of individual interest groups for introduction of a lower rate is avoided (Kesner-Škreb, 1996). CROATIAN ECONOMIC SURVEY 177
1996 - 1999 An analysis of household budgets, that is to be carried out in Croatia soon, will enable 12 this type of research. It should be noted that, due to the above reasons, all pressures for the introduction of several rates will be resisted. The real proportion of the regressive effect of VAT should be examined and put in relation to other tax forms and social transfers . Only then will competent evaluation of regressivity of the tax 12 system in Croatia be possible. But it does not necessarily have to be as big as some of its critics think it is. Regressivity should be observed in terms of dynamics and in a long-term sense, not just statically and in a short-term sense. First, dynamically, VAT is a consumption tax that, in its consumption form, stimulates investment and growth. A faster growth brings along increase in salaries and employment rate, which also makes the incomes of the poor to grow. Second, regressivity can also be observed in the long-term. At the moment when its spending starts in a flat-rate VAT system, the part of the income that was saved proportionally encumbers the spending of wealthy or poor citizens. Since saving is merely a postponed spending, it means that it will be taxed sooner or later - that is, it will become subject to VAT once it turns into spending. This way, the wealthy are not exempt from sales tax eventually, although they save more than the poor. They pay it when they turn their savings into spending. They will probably turn their savings into spending not before the end of their lives or their heirs will do it; however, at that moment, their spending will be taxed at the same rate as the spending of the poor. This is why regressivity has a different meaning when observed with respect to an income of one's lifetime or of future generations and not just with respect to current income. In such case, VAT does not seem to be regressive, but fully balanced with respect to a lifetime income, if we presume zero savings at the end of life (Wagner and Schmidt, 1996). In contrast to a short-term observation, which only considers the household budget of one wealthy and one poor citizen at one moment, this long-term observation fully changes the concept of regressivity of VAT. The first months of application of VAT have shown that, after all initial disagreements, this tax has become more and more accepted, the inflow to the budget has been growing beyond any expectations, price increase has not been dramatic and their reduction is expected in the following months, the underground economy has been gradually entering the VAT system, so a decrease in tax evasion is expected. These trends will probably allow imminent reduction of the relatively high (compared to other countries) rate of 22 percent (see Table 2). This would lead to additional tax relieves and reduction of tax distortions. 178 CROATIAN ECONOMIC SURVEY 1996 - 1999 The Croatian tax system is often criticized on the grounds that it relies on indirect taxes too much (in 1995, in the OECD countries, 6.6 percent of GDP accounts for sales tax without expenditure tax; in Croatia, it is 13 percent (see Table 6)). However, this situation has a few advantages for Croatia. That is, higher taxation with VAT allows export products to be stripped off domestic taxes to a larger extent, thus becoming more competitive in the international market. Same as contributions, income taxes and profit taxes cannot be deducted from the value of an export product and so they "move" to the international market, thus making a domestic product more costly. Income taxes and profit taxes in the Croatian system are relatively low. However, extremely high social security contributions (in 1995, they were 9.8 percent of GDP in the OECD countries and 18.5 percent in Croatia (see Table 6)) make it a large burden for export products (and not only them), because they cannot be excluded from their price. Excise taxes Excise taxes on oil derivatives, tobacco products, beer, non-alcoholic beverages, alcohol and automobiles were introduced in July 1994 (Official Gazette No. 51/94). It should be noted that expenditure excise taxes on coffee have been in place since 1993 (Official Gazette No. 66/93). At the end of 1997, excise taxes on beer, non-alcoholic beverages, automobiles (Official Gazette No. 139/97) were changed, as well as on oil derivatives (Official Gazette No. 51/94). These changes abolished the increased excise taxes on imported beer and non-alcoholic beverages, which equalized the tax status of imported and domestic products. However, excise taxes on tobacco have not been changed yet, so the imported tobacco has almost double excise tax than the domestic one. This practice should change, so that domestic industry is not protected by taxes (see Box 3.1). Excise taxes have also been extended to aircraft and vessels, which increased the number of products subject to excise taxes. Taxation of luxurious products adds to the progressivity of a tax system with a flat rate of VAT. Therefore, the number of luxurious products subject to excise tax should not be reduced. Although, taxation of negative externalities (oil derivatives, tobacco and alcohol) should not be changed because it reduces their spending. However, it should be re-examined whether excise taxes on non-alcoholic beverages are justified.
CROATIAN ECONOMIC SURVEY 179
1996 - 1999 4.2
. Analysis of Croatia's tax revenues In the beginning, a few notes about the information on tax revenue should be made in order to ensure easier comprehension of this section. In Croatia, the overall tax revenue is collected on three levels: they include taxes in the central government budget, taxes of the budgets of local government and contributions of extra-budgetary funds. When contributions of the extra-budgetary funds are added up to the central government budget taxes, we obtain the overall tax revenue (taxes and contributions) of the central government. The overall tax revenue can be presented on both the consolidated and the unconsolidated basis. On the third level, taxes are collected in local government units. So, when taxes on the local level are added up to the overall taxes of the central government (taxes of the central government budget and contributions of extra-budgetary funds), this gives us the information on the overall tax revenue of the general government. It can also be consolidated or unconsolidated. In the text, as well as in the tables, we will always indicate what information we refer to. Tax revenues of central government budget The economic truism says: a government needs to collect budgetary revenues if it wants to finance budget expenditures. Taxes are the main form of collecting budgetary funds. They account for over 90 percent of the central government budget in Croatia, while non-tax revenues, capital revenues and grants representing other budget sources account for the remaining 10 percent of funds. The past years have seen a fast growth of the tax burden, as measured by the share of tax revenues of the central government budget in GDP (Table 4 and Figure 2). While 26.6 percent of GDP was allocated by means of taxes in 1997, it was only 14.8 percent of GDP in 1991. This means that the tax burden had almost doubled in five years. However, the data from the period 1991-1993 cannot be considered as reliable, because of the disintegration of Yugoslavia, a large-scale war, economic instability and hyperinflation, and unreliable fiscal statistics and statistics of gross domestic product. Besides, similar to expenditure taxes, the laws on income tax and the profit tax did not start to apply before 1994. Thus, the data can be considered as reliable for analyses only as of 1994. 180 CROATIAN ECONOMIC SURVEY 1996 - 1999 Table 4
TAX REVENUES OF CENTRAL GOVERNMENT BUDGET AND GDP
1992 1993 1994 1995 1996 1997 Tax
rev enues (mil. HRK , current prices) 62.
80 502.
09 7, 891. 85 22,
377. 48 26, 505. 35 28, 530. 43 31, 338. 17 Increase compared t o t he prev
ious y ear (mil. HRK )
439. 29 7, 389. 76 14, 485. 63 4, 127. 87 2, 025. 08 2, 807. 74 Rat e of change (% ) -
64 1, 433. 90 109.
12 12.
51 9. 02 9. 90 G D P (mil. HRK . current prices) 425.
51 2, 725. 99 41,
814. 00 87, 441. 20 98, 382. 00 107, 255. 30 117, 873. 60 Increase compared t o t he prev
ious y ear (mil. HRK )
2, 300.
48 39,
088. 01 45, 627. 20 10, 940. 80 8, 873. 30 10, 618. 30 Rat e of change (% ) -
64 1. 433. 90 109.
12 12.
51 9. 02 9. 90 S hare of t ax rev enues in G D P
) 14.
76 18.
42 18.
87 25.
59 26.
94 26.
60 26.
59 M arginal t ax rat
e (% ) - 19. 10 18. 91 31.
75 37.
73 22.
82 26.
44 Ta x e la s ticity - 1 .2 9 1 .0 3 1 .6 8 1 .4 7 0 .8 5 0 .9 9
Ministry of F inance of the R epublic of Croatia. CROATIAN ECONOMIC SURVEY 181
1996 - 1999 If tax liability is settled within a certain period of time elapsing between the time when 13 a tax was generated and the time of payment, the real value of collected taxes will be higher at the time of collection than at the moment the liability was generated (Švaljek, 1995, page 68). They have turned out to be a particularly abundant source of revenues; therefore, they 14 were more than doubled between 1994 and 1997. Figure 2
SHARE OF CENTRAL GOVERNMENT BUDGET TAX IN GDP (in %) A sudden leap of the share of taxes in GDP takes place in 1994 - of as much as 6.7 percentage points (from 18.9 percent in 1993 to 25.6 percent in 1994). This leap of tax revenues can be explained by a number of reasons. First, 1994 was the first year of the stabilization program when prices dropped without notice (retail prices were 2.98 percent lower than in 1993). This was the time of the inverse Olivera -Tanzi effect, that is, the time of real increase of tax revenues. 13 Second, the implementation of the Income Tax and Profit Tax Act started at the beginning of that year, so tax revenues from this source grew by 2.2 percentage points. Third, in the middle of the same year, excise taxes were introduced. 14 Fourth, the financial police, established in 1992 (Financial Police Act, Official gazette No. 89/92), became organized by that time, which led to more regular collection of tax revenues. Fifth, a large number of taxpayers were included in the sales tax system, although tax rates were lowered and tax brackets within a tax were reduced (Fabijanèiæ and Barac, 1996). 182 CROATIAN ECONOMIC SURVEY 1996 - 1999
The increase in the share of tax revenues in GDP continued in 1995, when it reached its maximum of 26.9 percent. After the maximum reached in 1995, the share of taxes in GDP slowly started to drop (by 0.3 percentage points compared to the previous year when it was at its maximum). This drop was a result of the lowering of the basic sales tax rate from 20 percent to 15 percent, which also caused reduction of the average burden of the turnover in the ultimate consumption from 32 percent to 26.5 percent. The same tendency continued in 1997, i.e. the share of tax revenues stabilized at the level of 26.6 percent of GDP. The dynamics of taxes and GDP can also be analyzed by means of tax elasticity, which is measured as the percentage of change of taxes divided by the percentage of change of GDP over a period of time (in this case - one year). Tax elasticity over 1.0 indicates that the growth of tax revenues is faster than the growth of GDP. Tax elasticity was over 1.0 in the period 1992-1995, with its maximum of 1.68 in 1994 (Table 4). This means that taxes in this period grew faster than GDP, with the fastest growth recorded in 1994, as compared to 1993. After 1995, the proportions of tax elasticity fell below 1.0, which indicates that the growth of GDP was faster than the growth of tax revenues. Similar trends also have marginal tax rates that measure absolute tax growth compared to absolute GDP growth in one period (in this case - one year). The marginal tax rate reached its highest level in 1995. In that year, 37.7 percent of GDP growth was allocated for taxes, unlike in 1992, when the percentage of GDP allocated for taxes was almost half less, i.e. only 19.1 percent. After 1995, marginal allocation for taxes dropped in 1996 and grew again in 1997, when tax growth exceeded GDP growth, which also made the marginal tax rate higher. Taxes and social security contributions In order to perceive the overall tax burden in addition to taxes, the amount of contributions to extra-budgetary funds should also be taken into 15 account. After the drop from 19.5 percent in 1991 to 12.9 percent in 1993, the share of the contributions in GDP continued to grow once more and again reached the level of 19 percent in 1997 (see Table 5). Taxes after all are a dominant way of financing the central government: after 1992, some 60 percent of revenues have continually been collected through taxes and 40 percent through contributions. The overall tax and contribution burden on the central government after a sudden
CROATIAN ECONOMIC SURVEY 183
1996 - 1999 The Ministry of Finance has been providing these data since 1994. The local 16 government budgets make up around 3 percent of GDP on a consolidated basis and around 7 percent of GDP on a unconsolidated basis. increase from 31.8 percent of GDP in 1993 to 42.5 percent of GDP in 1994 continues to grow, reaching 45.6 percent of GDP in 1997 (unconsolidated data). The overall tax and contribution burden was thus almost 14 percentage points of GDP higher than in the early nineties. Defense expenditures during the war, numerous displaced persons and refugees and wide-ranging social rights inherited from the abandoned socialist system are only some of the budget expenditures that caused great pressure on tax and contribution growth in those years. An extenuating circumstance was the stabilization of prices, which ensured the functioning of the inverse Tanzi-Olivera effect and growth of real tax revenues without major interference in the tax system. So far we have analyzed the data on the central government level. This means the data that include the state budget taxes and extra-budgetary funds contributions. All these data were unconsolidated. But if we observe the data for the general government which, besides the state budget and extra-budgetary funds, also contain the tax revenues of local government units, and if the data are consolidated, the situation is very similar. Thus, the allocation of GDP on the general consolidated state level by means of taxes and contributions was as follows: 43.19 percent in 1994, 44.40 percent in 1995 and 44.72 percent in 1996 (Ministry of Finance, 1998) . 16 Compared levels of tax revenues of Croatia and some other countries The level of burden of tax revenues in Croatia should be compared with the same level in other transition countries, as well as in countries with a market economy. This could answer the question whether Croatian citizens pay relatively high taxes. The tax burden in Croatia will be compared with the burden in the advanced transition countries: the Czech Republic, Hungary and Poland (they also have similar levels of income per capita) and the neighboring countries that are, at the same time, Croatia's main trading partners: Austria, Italy and Germany. The data are shown in Table 6.
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